Brace for a bumpy ride along the bottom

Notwithstanding better-than-expected U.S. job data, fears continue to grow that the U.S. economy is slipping back into recession. Coupled with the untamed Eurozone debt crisis, that fear is weighing on the global economy.

As the curtain came down on America’s manufactured debt default drama, the veil lifted on a slew of grim global economic data. A brutal plunge in global financial markets and panic selling followed as investors trained their attention back on fundamentals that look very bad. Even gold, the epitome of safe haven assets, couldn’t escape the downdraft.

While the market waits for the storm to subside, financial experts say there are good reasons to be worried about the renewed uncertainty.

“The stock market is sending a loud and clear message that investors are seriously doubting the second-half rebound story for the U.S. and global economy,” said Douglas Porter, deputy chief economist, BMO Capital Markets, during a conference call this morning.

“The downdraft in stocks was first triggered by Washington’s self-inflicted debt crisis as well as persistent concerns over Europe’s very real debt crisis and the underwhelming response to it including yesterday’s muddled response by the ECB and the signs of global economy struggling heavily.”

The concern is that with the U.S. economy cruising at such low altitude, and at such low speed, it won’t take much to push it into another downturn. “The risk now is that this sudden weakness we’ve seen in equities in turn hits confidence and spending both for consumers and businesses.”

Gregg S. Fisher, president and chief investment officer, Gerstein Fisher Inc, an investment manager in New York, says there is a concern we may be headed for another recession. “This downward momentum in the market can take on a life of its own: panicked investors sell, pushing prices down, which leads to more panicked investors selling, pushing prices down further, and so on.”

This extreme volatility in the market is an indication that the “cautious optimism” of last year has now turned into doubt and despair. This shift is not divorced from fundamentals, says Nigel Gault, chief U.S. economist with global consulting firm IHS Global Insight. He says dipping GDP data, a rising unemployment rate and a pullback in manufacturing are “standard rule-of-thumb indicators” that point to a looming recession.

“Plunging stock markets are a consequence of the fear of recession, and themselves exacerbate that fear by destroying wealth and raising the cost of equity,” says Gault.

Porter couldn’t agree more. “It is fair to say that because of the wrangling in Washington [and] the concerns over Europe, the risks of a recession have unfortunately risen in the last couple of weeks [and have] delivered a hit to the equity markets.”

What’s worse is that there isn’t room for the U.S. policymakers to do much about it at this point. “[The U.S.] fiscal policy is basically on ice; in fact, with this week’s debt ceiling deal there will be cuts on the fiscal policy front of at least $20 billion next year and monetary policy really doesn’t have a lot of room to manoeuvre with U.S. interest rates effectively on zero,” says Porter.

Canada, in contrast to most of the industrialized world, is better positioned to make some tactical moves. “There is room for Canadian policymakers to help support the economy or cushion the blow [by cutting interest rates] if weather does get heavy,” says Porter.

Amid gathering clouds of economic uncertainty, however, shines a few relative bright spots. First, the big drop in oil prices will bring some relief at the pumps. Porter says the higher oil price was one of the leading causes of the slowdown in the U.S. economy. Secondly, the huge bond market rally will bring considerable relief for homeowners by spurring refinancing activity as a result of a slide in bond yields.

Fisher reels off a couple more silver linings. “One interesting side effect of this is that the recent declines create a situation where the expected return on stocks is beginning to look far more attractive when we compare them to ‘safer assets’ like bonds.”

Investors, he says, are at the point at which they can receive better income streams from a collection of large cap businesses than a 10-year government bond.

He advises investors to maintain a healthy liquidity cushion. “This allows you the flexibility to capitalize on opportunities that might present themselves, and/or the financial breathing room to weather a period of distress.”

Investors have an important role to play in volatile market conditions, says Serge Pepin, head of BMO Investments Inc.

“These types of upheavals are not new to the marketplace,” says Pepin. “However difficult they are to go through, a well diversified portfolio will always win out; and checking ones emotion at the door is perhaps ones best defence.”